Third Extract from the Book

Investing for Beginners Exposed: Or What Investment Consultants Hide from You

NINTH MEETING – INVESTMENT FUNDS

FINANCE IS THE ART OF PASSING CURRENCY FROM HAND TO HAND UNTIL IT FINALLY DISAPPEARS.

John Updike

The week passed as if a short leg on the way to sea except, this time, I spent the whole evening before the lecture examining various investment funds.

The following day, I opened the door to Victor’s building. This time we had to wait a couple of minutes for Anthony, but when he arrived, Victor began his speech, “Before moving forward, I’d like your homework,” Victor took our printouts, scanned them hastily and looked content. However, he offered no comments, put them on the shelf and continued, “You are already aware of the principal items concerning investment asset classes, how to arrange them and what proportions maintain in your portfolio. The ways to do so are diverse. But now you have to ask yourself a ques-tion. In principle, invest-ments in each asset class can be made directly or through collective investment instruments as funds, no matter whether stocks, bonds, commodities, money market or real estate. Which way do you want to invest your portfolio?”

“Does it make any difference?” Anthony doubted.

“The difference can be significant in one case and absolutely invisible in another. Let’s try to look at those differences. For con-venience sake, let’s segregate the two fundamental investment methods. One of them is direct investment. That is, if you feel like investing in the shares of a US companies, choose a market and select the shares for your investment, then, buy those shares on the exchange. After purchasing them, you watch the market, study its variations, read and analyze financial results from various companies, waiting for a chance to sell your securities. If, for some reason, the stock you obtained doesn’t satisfy you any longer, you sell it and look for a better investment. This is a tedious and time-consuming process. You can alleviate some of the difficulty here if you simply buy a US equity mutual fund, which will do much of the job for you. But you never can tell, whether it will do better or worse than you would have had, if you bought and sold the shares according to your own methodology."

“Does that mean that the most important criterion for choosing an investment method is the time you can allocate for investing?” I tried to guess.

“Yes, indeed that’s a very important criterion,” Victor echoed me satisfied. “Because, if you know in advance, that you don’t have much time to deal with your investments and rather won’t be eager to do so as such things do not appeal to you, you should leave most of the duties to others and enjoy the result. This is an essentially posi-tive element of investing in funds. You might also prefer funds if you don’t have sufficient information about a particular investment. This is especially important in cases where you want to invest in certain little-developed markets, where information in your language is rather limited or unavailable. It goes without saying that investing in such markets is a wildcat and if you invest there by guessing, the results will surely be unpredictable.

“But sometimes circumstances require you to invest through collective investment subjects, for example, mutual funds. Also, it may be the case that your access to information is good, but your knowledge of the far-away market is limited, which can set you back to square one. Or, even though you have all the pertinent information and you care to diversify your portfolio properly, you don’t have sufficient time to analyze investments in all markets, as there is a tremendous amount of information your time is short. For these reasons, many investors cannot skip investment funds, especially when speaking of bonds. I mentioned before that bonds must be extremely well diversified and their analysis can be quite compli-cated, so I strongly recommend you to invest in bond funds rather than individual bonds themselves.”

“So why should I invest in stocks directly?” I asked, though personally I didn’t trust funds.

“There are certain reasons. If you invest only in funds, you can hardly expect large or multiple increases in value over the short term. But this is quite common with stocks. The value of a particular stock may increase many times, so at least from a theoretical point of view, you’ll have a good opportunity to sell it at a high profit. You also can invest in small-cap companies, which are usually too small for funds to purchase. If you invested only in funds, you wouldn’t have the chance to invest in small-cap companies. Also, investing in the shares of concrete companies is exciting and can be an enjoyable process for some. That’s equally important when it comes to investing. But if you frequently suffer from anxiety over the decisions you take and eat your heart out for your mistakes, you are better off staying away from such a bumpy ride by investing through funds.

“There is one more thing that is the most important reason of all not to invest in funds – fees. There’s no such thing as a free ride and, unfortunately, even some things that look gratis at first sight aren’t free after all. In this field in particular, investors who are unaware can easily be overwhelmed by very expensive products.”

“Are we talking about management fees?” Anthony looked inter-ested.

“Them as well. But also, different taxes can be hidden under various headings, so it is important to pay careful attention to those, even if you have no interest in the markets, their products and other details, you always need to inquire about the cost.”

“But these charges aren’t much, maybe one or two percent,” Anthony argued.

“Well, let’s see if the fees are so insignificant. For example, you’ll most likely find conditions like these in a standard proposal: manage-ment fee – two percent; load fee – two more percent; and something like one percent internal fund charges, which goes to cover the fund’s administration expenditures. So if you invested in this fund for one year and in a year bought another, all the expenditures would be yearly. Still look insignificant? If it still doesn’t look like much to you, remember that the expected average return is only ten percent per year. Ten percent is before the deductions of all such fees and charges.

“So out of ten percent profit, only five percent would remain, though the risk would not decrease one bit. That’s half of your profit! Still look small? I agree that one or two percent do not look like much given frequent and high market fluctuations, but trust me, they can be very weighty for the long-term profitability of your portfolio. Large and repeated expenditures can so diminish the return on your investments that saving your money in a bank account would look more reasonable. Therefore, I always recommend avoiding any alterations in the portfolio unless they are absolutely necessity. Sometimes doing so can bring the house down. It may be painful to refrain from any action, but don’t forget everything has a price and if you don’t want to lose money little by little, the best option for you is to measure twice and cut once.”

“If you look after the pennies, the dollars will look after them-selves,” Anthony stopped arguing.

“You can be sure about that,” Victor continued. ”In many cases, beginning investors don’t pick products with low expenses. Further, they don’t pick themselves; somebody does the job for them, none other than people from banks or brokers. As a rule, these people are going to prefer the investment products they or their partners pro-duce. When the customer visits his or her investment consultant, who is really a seller of certain funds, he or she can expect they won’t be offered the best product, but a variant that is the most profitable for the distributor.

“The worldwide market of investment funds can be divided into two large groups. The first group covers true investment products and the second deals with marketing products. True investment products are exactly the products investors should buy. These are clear and simple and not overloaded with charges. Usually nobody cares to offer or advertise them, because the profits from them don’t often stay above water. Such products are true investments. Meanwhile, the situation is reverse with marketing funds. Marketing product funds are always available on display and somebody is always ready to offer them for you. No doubt they are not much better than low cost funds, likely they only have higher fees and charges. Marketing pro-duct funds employ powerful distribution networks and systems. In some cases, marketing expenditures are incorporated into the internal costs of the fund. This means that the fund is advertised for your money to be sold to you! It sounds preposterous and cruel, but unfor-tunately, it is reality.”

“So investing in index funds is a better option, isn’t it?” I asked.

“I don’t support either index or actively managed funds. I am in favor of small charges,” Victor said as if boasting. “Index funds are funds that mirror the composition of the principal indices, and most often, their fees and charges are low, which is an undisputed advan-tage. However, the fees and charges of some actively managed funds are not compulsory large either. You just always must be on alert. The results of managed funds aren‘t necessary better than those of index funds, sometimes they are even to the contrary.

“Typically, each investment fund has a comparative index – a benchmark – and plays various tricks to that end. First, each com-parative index must accurately reflect the risk level of the fund and provided that it has a lower risk than the fund, it may give you the impression that the results of the fund are far superior to the com-parative index in a growth period, which in its own turn, should mean that the fund is administered competently. However, in order to assess proper administration of the fund, we must see a long period with the cycles of increases and decreases. If we see that the fund beats the benchmark in the rising period and drops more than the index during down periods, this implies that the comparative index is far less risky than the fund.

“Also, rather often endeavoring to show the fund’s superior results in comparison, indices that do not include dividends are used for comparison. Just think, the fund always earns dividends and they increase the value of the fund, however, they are compared with indices, which don’t include the added value of dividends. Just for this reason alone, depending on the market, the benchmark index should fall behind the comparison fund about two-three percent each year. So bending the truth a bit allows the results of the fund to look better at least by two percent versus the comparative index, provided the latter doesn’t include the reinvestment of dividends. But time after time, this two percent melts down owing to the administration fees for the incurred outlay, depository’s charges, commissions for transactions, audit fees, etc. It’s the investor who pays all these fees and charges after procurement of the funds at his own expense, only they are immediately deducted from the value of the fund, so many investors don’t complain that they pay them.”

“How can one trim the sails before the wind in a tangled skein?” I asked feeling irritated. The longer Victor continued talking, the more complicated the matter appeared. Most likely all of these fees and charges were hard to find; I could easily get weighed down in those booklets and still be taken for a ride in the end.

“How? Just watch and see. That is, if you don’t want your money taking wings. As the saying goes, nothing ventured, nothing gained. Short of time? Then look for specialists to help you, but we’ll talk a bit later about it. Now I’d like to return to discussing investment funds.”

“Fine, but I have one more question on the matter,” Anthony said impatiently.

“Go ahead.”

“If the fees and charges of the index and actively managed funds would be alike, which should be preferred?”

"If the fees and charges are similar or slightly higher in the active fund, but that is quite rare, the actively managed fund would be preferable. But only in the cases where its activity creates value. As I said before, here the results must be compared with the fund’s benchmark. I want to call your attention to the length of the period and the same managers of the fund staying in their positions. If the fund managers have changed, the fund’s prior results are totally useless. A good fund manager can create added value to the fund’s results, because index funds invest in only largest companies and the actively managed funds are granted more freedom. So, in this case, actively managed funds with low fees and charges could be a good choice but, give the devil his due, most fund managers don’t produce added value, but conversely, they demolish it over the long term. Don’t forget, every percent matters.”

“So why do people still invest in undeserving funds?” Anthony kept pressing Victor.

“People invest in the things they are offered. Offered by the environment, marketing and distribution networks. People tend to choose the easiest way that demands the least effort and discom-fort. That’s the crux of the matter.”

“What should I do if I fail to find a fund with low fees and charges?” I inquired.

“This can be the case, as the distribution networks of the funds with low fees and charges aren’t developed widely. Minor or me-dium-sized investors are most likely to find themselves in similar situations. But always remember that if there is a will, there is a way. If you cannot find funds with low fees and charges, inquire as to the funds traded in the markets called exchange-traded funds (or ETFs). The variety of such funds is rather large and is continually growing.

“In principal, normal ETFs are like regular index funds, except they are traded in the market and but available worldwide through any brokerage firm. Often ETFs can be the best option for investors. However, the main disadvantage can be fairly large trading fees if you invest in foreign exchange-traded funds, however, nine times out of ten, ETF purchases and sales are charged like stocks in the same market. If you intend to buy ETFs in a foreign market, the minimum commission should be higher.

“The principal advantage of exchange-traded funds is their low management fee and the absence of distribution charges. Instead there are commissions for the transaction. If you invest a large amount, you are at an advantage with ETFs. But make no mistake, if you are a rookie investor and the commission for the fund transaction is more than one percent of the value of the fund, look for a more acceptable alternative.”

“And what then, if an acceptable exchange-traded fund isn’t available in a desired market, which meets the eligible index and there are no other funds with low fees and charges?” I pressed Victor.

“If you cannot trace a proper ETF, but can buy shares in a desirable market for a comparatively low commission, buy them instead of the fund, even if you are unaware of the best companies in which to invest and you are a stranger in the market. In this case, you have to produce your own ‘index fund.’ As a rule, it is not hard to find the main stock index. What you need to do is copy the com-position of the index and the value of your shares will change along with the value of the whole market. An exact, one hundred percent repetition of the index isn’t necessary. It is more important that you try to keep similar proportions in order to maintain a similar risk level.”

“What fund charges are acceptable?” I wanted to hear more pre-cise figures.

“First things first; fees and charges depend on the asset class and development of the market. The fees and charges in bond funds are less than those in of equity funds. Fees and charges are also lower in large and liquid markets than they are in emerging markets. The lower the fees and charges, certainly, the better for the investor. I suggest the target values don’t exceed one percent for equity funds and a half percent for bond funds. Ideally, the outlay deducted from the fund should not exceed such values; this number is given in the fund descriptions as the ‘total expense ratio.’ The higher this ration, the larger the portion of investor asset expropriated for various fund expenditures. Searching for funds with low fees and charges may be especially difficult in more exotic markets. This doesn’t mean investing in these markets is senseless, but you must use your head to decide if it is profitable for your portfolio and makes it more effec-tive. Just never forget that, if the management fee is two percent, which may seem small, but if you add one percent for other fund expenses and one percent of the sales or redemption fee, it may amount to nearly a half of your average annual profitability. Therefore, always deal with fees and charges very responsibly.”

“How should we view performance fees? Are they better than administration fees taken from the asset value?” Anthony asked, seeming to have encountered such fee.

“Performance fees, also called success fees, have their pros and cons. This fee is payable from the fund’s unit value increase, there-fore, proponents say it offers the manager incentive to strive for better results. However, skeptics say it makes the manager take blind risks. Greater risk increases fluctuations in the value of the fund and it makes the performance fee higher in the climb period. The manag-ers do have only to survive a decline period and wait for another hype to take huge performance fee.”

“What about distribution fees? Which is the optimum?” my colleague pressed further with questions.

“They are optimum when there are none of them. Purchase or redemption fees must be ranked with equal sporting chances. The practical difference between procurement fees and redemption fees for investors is imperceptible. This is more a marketing trick, mis-leading profit distribution between the management company and the broker. If there is a difference between them, it’s very insignificant for you. Provided you cannot find a fund with low or no purchase fees, don’t forget about the possibility of buying exchange-traded funds.

“One more thing I want to add about funds is that you may come across funds of funds, which indeed are not the best products. Yes, they're well diversified, but such funds take fees and charges and invest their assets in other funds, which in turn, also take fees and charges. Under these circumstances, they’re skim the cream off you twice.”

“If I understand you correctly,” I wanted to summarize, “you mean that from the standpoint of fees and charges, the most effective investment form is direct investment in securities, bypassing funds?”

“In most cases, yes,” Victor didn’t deny my conclusion. “However, as I said before, you may not be on the crest of a wave every time and manage to buy or sell at the drop of a hat, besides buying securities directly may produce additional risks. Conse-quently, I recommend investing in the shares only after gaining particular experience. I’d like to tell you a lot more but, unfortu-nately, our time is up for today.”

“Those ETF funds, they are likely the best option in some cases, aren’t they?” I wanted to know more, despite time running short.

“In order to determine which option is best, you have to look at the entire spectrum. The mere mention of listed funds doesn’t guarantee low fees. Fees and charges must always be checked and rechecked. For commissions, also try to pick the best. With regard to ETFs, it is critically important to pay attention to their names – if you aren’t a professional, try to avoid various Ultra, Short, Ultra Short or the like ETFs produced with the help of derivatives. Prefer only traditional funds, because ETFs produced with derivative instru-ments, such as Ultra ETFs, Short ETFs, Ultra Short ETFs, are likely to bring much poorer results in the long-term than common ETFs on the same index.”

“As far as I can tell, Ultra ETF means that value of the fund grows twice as fast as the index, doesn’t it? Why should the results be infe-rior?” I was about to initiate a small dispute.

“Within one day, this could be absolutely true – Ultra ETFs would grow twice as fast, but also suffer a double contraction when the in-dex drops. These funds serve a purpose only when the market is sky-rocketing. However, usually the markets drop, rise, drop again, rise again and frequent jumps are common. Ultra ETFs are like jumping with double force and the decreased percent is always bigger than the increased percent, so a poorer result is already mathematically prede-termined over the long term.

“That is a lot for today.”

“What’s our next task?” Anthony was curious and seemed eager about the next assignment, although he had been rather skeptical about them in the beginning.

“Oh, of course, your homework. This should be really interesting, almost like a computer game. For this assignment, you will need to do the following: download a demo trading platform on the Forex market from the Internet and do your best to double your virtual investment to see what comes of it. We will talk about your expe-rience next time.”

“No problem,” we reassured Victor that we would cope with the assignment and after saying good-bye took to the street.

I began the task Victor assigned as soon I had a free evening. Actually, even before then, I checked the prices of my stocks, which had slipped my mind for a spell. Lately, I had found it difficult to find time for my investments, although I had spent much time on my studies and other involvements.

I noticed the market hadn’t changed much since I’d last looked. The frenzied downturn seemed to have come to an end, but it looked like nervousness had befallen it from time to time, with sudden rises and falls striking seemingly at whim; however, a solid tendency was hard to trace. Of my three remaining stocks, two had undergone a slight decrease in value. Those were the shares of the supermarket and telecommunications companies. This digression was compen-sated for by the increased value of the pharmaceutical company, as it comprised the largest portion of my portfolio. All in all, the value of my portfolio remained about twenty two thousand dollars.

A closer view of my investment portfolio revealed that it was absolutely hopeless according to Victor’s lessons. I believed it had to be re-mastered, by definition. However, before taking steps in that direction, it would be wise to wait until the end of the training to avoid having to make more changes later or omitting important details.

After putting my ideas about the portfolio away, I progressed to the assigned task. The Forex market did not fascinate me much, though I had heard quite a lot about it. Currency trades happen everywhere worldwide, round the clock, during all working hours and halt with the largest turnovers in the world. It’s a gigantic industry and, of course, somebody rakes in money from it.

I didn’t know why Victor had given us this particular assignment, but the idea struck me not averse to cracking it. It took me less than one minute to find a website with a free trial account version of the Forex market on the Internet. After downloading the program and its installing it, within a couple of minutes, trading and sitting on the virtual gravy train were the only two things remaining.

To be frank, it took me a while to figure out the program, but after ten minutes, I was prepared and able to begin active trading. After a few larger transactions, my limit was soon exhausted and I had to wait for further moves in the markets. The lull before the first results began to emerge was not long. Two transactions brought consider-able losses, but the remaining three redeemed the loss of the previous two with gusto.

I soon became restless and as soon as some assets were available I quickly began another transaction. My guesses were based on the analysis of schedules and intuition. After some hours of playing the game, to my great surprise, my virtual account had significantly increased, but had not doubled, as my assignment required. I con-cluded that I had done for my first session.

The following day, I connected the account again and did my best to repeat the record of the previous success, but yesterday’s unex-pected fortune was a flash in the pan. Of course, there were some successful and unsuccessful trades, but the general account remained almost without a change.

On the third day, the variations were more remarkable, but still not in my favor. No matter what I did, the account was soon nearly empty so that brought the end of my efforts in the currency market...

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